By ROBERT J. SHILLER
Home prices have been climbing. They have risen 27 percent nationally since 2012, even more in places like San Francisco. But why worry? If you accept the efficient markets theory — and believe that real estate is an efficient market — then these prices are based on “new information,” even if you don’t know what that information is.
The problem with this kind of thinking is that the efficient markets theory is at best a half-truth, as a voluminous literature on market anomalies shows. What’s more, even that half-truth is grounded mainly in the stock market, which attracts professional investors who sometimes do make the market behave efficiently.
The housing market is another matter. It is far less rational than even the often irrational stock market, for a couple of important reasons. First, most investors find it difficult to understand how housing supply responds to changes in demand. Only a small minority of people think carefully about such things. Second, it is very hard for the minority of smart-money investors who do understand such matters to bet against bubble-level prices in real estate markets. In housing, the smart money has relatively little voice.
For the first point, in “A Nation of Gamblers: Real Estate Speculation and American History,” a presentation at the 2013 American Economic Association convention, Edward L. Glaeser of Harvard University reviewed real estate booms and busts. He showed how real estate investors have repeatedly made the mistake of neglecting the supply response to rising prices. In the Alabama cotton farmland boom of 1815 to 1819, for example, high cotton prices seemed to justify high prices for cotton land. What most investors failed to see at the time was that these cotton prices would induce new farmers around the world to begin to grow cotton. That same failure to anticipate how supply can respond to demand applies to many forms of real estate today. Developers and builders will, one way or another, exploit overpricing, increasing effective supply, in that way bringing real estate prices down.
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